Four Key Benefits of Making the Tax cuts
Permanent and
fully in effect now
Making the tax rate cuts permanent and
fully effective now is the right short-term and long-term policy
for four key reasons.
Reason #1: Certainty about tax rates
improves general incentives to work, save, and invest.
People act on their ambitions and
expectations of the future. In tax policy, certainty, immediacy,
and permanence are commonsense principles that lead to effective
planning. Uncertainty about the future breeds caution and makes it
much more difficult for people and businesses to plan properly.
Today, there are many unknowns about the
future--the war on terrorism and possible terrorist attacks, a
potential war in Iraq, the health of the economy, and the promise
of lower future tax rates. Although some of these things are
difficult for policymakers to control, tax policy is something they
can control. The uncertainty about how much the government will
punish success--that is, how much income it will take in taxes--in
the future is causing economic stagnation now. As Princeton
University Economics Professor Harvey S. Rosen noted earlier this
year, after studying the effects of permanent vs. temporary tax
rate reductions, "Clearly, it is undesirable to have massive
uncertainty about what the tax law will look like at the beginning
of the next decade."
Temporary tax rate reductions do not lower
government-imposed barriers to working, saving, investing, and
developing a business; instead, they cause people merely to shift
the timing of such productive activities. In contrast, making last
year's tax rate cuts permanent would reduce uncertainty about tax
rates in the future and would genuinely lower government obstacles
to those activities. As Professor Rosen explains, "A natural way to
resolve the uncertainty is to pass legislation now to make EGTRRA
[the Economic Growth and Tax Relief Reconciliation Act of 2001]
permanent."
Making the tax rate reductions fully
effective now instead of slowly phasing them in over several years
would bring the future benefits of those changes forward to today
and provide even greater certainty about tax rates in the future.
Tax rate cuts now help the economy substantially now. While making
the tax rate cuts permanent would be an important and positive
step, making the tax rate reductions fully effective immediately
would be an additional improvement. Tax rate reductions that take
effect in the future would help the economy more in the future but
will have less effect on incentives now to work, save, invest, and
develop businesses. Tax rate cuts now would dramatically benefit
the economy now.
Future tax rate reductions are uncertain
because politicians ultimately may decide to delay them further or
prevent them from occurring at all. Already, Senate Majority Leader
Thomas Daschle (D-SD) has gone on record against the 2001 tax cuts,
stating "I don't believe we ought to make those tax cuts
permanent." Senator Edward Kennedy
(D-MA) has called for delaying the scheduled cuts, and
Representative Ellen Tauscher (D-CA) has suggested postponing
planned rate cuts if there were no budget surplus. Workers,
investors, and entrepreneurs understand this risk and thus discount
the likelihood that the tax rate cuts will materialize in the
future.
Tax
cuts delayed usually mean tax cuts denied. Tax cuts subject to a
budget surplus "trigger" likely will not happen, since politicians
almost certainly will find ways to spend the people's money. From a
budget perspective, a real trigger should be placed on government
spending rather than on tax rate cuts. Moving the tax rate
reductions scheduled for the future to the present would decrease
the drag on the economy today and remove uncertainty about whether
the policy will ever take place.
Reason #2: Making the tax rate cuts
permanent and fully effective now would especially help small
businesses and workers.
Small businesses are the engine of the
economy and create countless new jobs. Many small-business owners
pay taxes through the individual income tax rather than the
corporate income tax, often paying the top individual tax rate.
These entrepreneurs make their decisions about whether to invest,
expand, and hire more people based on their anticipated future
after-tax profits.
That
relationship is why the top tax rate is critical to new job
creation. If entrepreneurs are uncertain about how much the
government will punish their success--that is, take from them in
taxes--in the future, or if they know that tax rates definitely
will rise in the future, then they will resist expanding operations
today since the after-tax profits needed to support that growth
likely will not materialize.
Small firms, then, are particularly
sensitive to tax rates. A study released by the National Bureau of
Economic Research (NBER) that looked at changes in small firms
between 1985 and 1988 (when the tax rates changed) highlights this
relationship. Its authors conclude that "the greater the decrease
in the sole proprietor's marginal tax rate between 1985 and 1988,
the greater the increase in the size of his or her business." Therefore,
making the tax rate reductions permanent and effective now would
immediately increase confidence and would spur small-business
growth, prompting increased wages and lower unemployment among
workers, and increasing jobs and prosperity for workers and
families today.
Conversely, failing to make the tax rate
cuts permanent not only harms workers now, but also would
dramatically hurt people in the future. If the tax rate reductions
are not made permanent and instead expire in 2011, the increase in
many tax rates that year to pre-2001 levels will probably mean the
largest tax increase in history. People whose wages had grown
faster than inflation between now and 2011 would face higher tax
rates in 2011 than they did in 2001. (See text box, "The Cost to
People in 2004 of Repealing the 2001 Tax Cuts in 2003.")
Even
if only the top individual tax rate returned to its pre-2001 level,
workers not paying that rate would suffer along with those who face
that rate increase. The reason: Many people who pay lower tax rates
work or would like to work at small companies whose owners pay the
top tax rate. Imposing high tax rates on small-business owners
forces them to reduce their payrolls and/or workers' salaries.
Congress, by failing to make the tax rate
cuts permanent and allowing the rate reductions--especially the
reduction in the top rate paid by many small-business owners--to
expire in 2011 is thus effectively imposing a tax increase on small
businesses that hurts both their current and potential workers. As
the authors of the NBER study pointed out, their findings were
"consistent with the view that raising income tax rates discourages
the growth of small businesses."
Policymakers cannot help employees by
punishing employers. By increasing certainty about the future,
making the 2001 tax rate cuts permanent and fully effective
immediately would increase the benefits of the rate reductions for
all taxpayers. Government would take less in taxes from people, and
people would know going forward that they would keep more of their
own money. Government would decrease its punishment of working,
saving, investing, and developing a business but increase
incentives (rewards) for engaging in those productive activities.
With permanent and immediate tax rate reductions, small-business
owners would have greater resources to hire people and increase
salaries right away, as well as greater confidence that they would
have the means to do so in the future.
Reason #3: Making the tax cuts permanent
and fully effective immediately would bolster the recovery now and
foster greater growth over time.
The
economy is an aggregation of the actions of people in their roles
as producers and consumers. The actions of small-business owners
and others reverberate throughout and affect the entire
economy.
Though the economy is rebounding from its
recession, it could be performing more strongly; but doubts persist
about its prospects. Making last year's tax cut package permanent
and completely effective now would bolster the recovery and foster
even greater growth by creating more jobs, increasing wages,
expanding prosperity, and decreasing poverty. Such a policy also
would lessen the chances of another slowdown--a situation known as
a "double-dip" recession.
Not
making last year's tax cut package permanent creates unnecessary
and counterproductive uncertainty that makes it difficult for
individuals and businesses to plan for the future. The problem
faced by small-business owners who are considering expanding their
operations is just one example of the detrimental economic effects
of not making the tax rate cuts permanent. The current uncertainty
also distorts the decisions of those who are trying to plan for the
death tax.
Under current law, the death tax burden
declines slowly over 10 years until it is eliminated in 2010.
Unless something is done, however, in 2011 it will return with
punitive rates. This bizarre scenario makes
it impossible for people to plan their finances, since they cannot
know when they will die and be subject to the death tax. Clearly,
people cannot count on dying in 2010 when there will be no death
tax. Therefore, small-business owners, farmers, and others must
assume that the death tax will still exist and must employ costly
and otherwise economically unproductive tactics to minimize the
future effects of that tax. Consequently, they divert resources
from economically constructive activities, such as saving,
investing, and business development, to economically less
productive tax techniques designed only to limit their exposure to
the death tax.
This
inefficient result harms the economy today as people engage less in
those productive activities and more in trying to reduce their
death tax liability. Making last year's tax cut permanent and fully
effective now would decrease their uncertainty about future tax
conditions and allow the resources that otherwise would be used to
meet that uncertainty to flow to beneficial activities that help
the economy today, creating jobs and increasing wages
immediately.
Many
economists across the range of ideologies have suggested that the
economy would benefit from eliminating the death tax. For example,
Joseph Stiglitz, a Nobel Prize-winning economist and Chairman of
the Council of Economic Advisers under President Bill Clinton, has
observed that if the death tax does lower saving, then the pool of
money to invest will fall, resulting in lower wages for workers.
Recent research has found that the death
tax does, indeed, decrease saving. One study suggests that
eliminating the death tax would significantly benefit the economy
by resulting in a 1.5 percent increase in wealth accumulation. Clearly,
making last year's tax cut permanent and fully effective now would
eliminate death taxes immediately, quickly bringing about enormous
benefits to the economy and even to workers who would not pay death
taxes.
Taxes inflict a cost on the taxpayer and
the economy because they distort incentives and, as a result,
economic activity. The more government taxes something (working,
saving, investing, or developing a business), the less it occurs.
This economic loss surpasses the revenue government takes and
represents sheer waste for the economy. The higher the tax rate,
the greater this waste will be.
Another study suggests that the last
dollar of tax revenue collected by the U.S. government costs 33.4
cents in terms of this waste imposed on the economy. Using this
figure, Professor Rosen estimates that the current tax rate
reductions in 2010 will decrease this loss by $39.5 billion--"about
the size of last year's tax rebate." Making the tax rate cuts
permanent would make the reduction in waste permanent, and making
the tax rate cuts fully effective now would accelerate that benefit
to today instead of postponing it to 2010.
Since small businesses are central to the
U.S. economy, the effects of tax policy on small businesses are
key. High income tax rates are a drag on small business
development. Consequently, making permanent the income tax rate
reductions enacted last year would spur small business growth, as
noted above, expanding jobs and increasing wages. And, again,
making the tax rate reductions effective immediately would bring
those benefits forward to today. Potential entrepreneurs would be
more inclined to start their own businesses, since they would be
certain about the tax rates they would face.
While it is not easy to determine exactly
the extent of the beneficial effects of tax rate reductions on the
overall economy, one study estimates that a 5 percentage point
reduction in income tax rates would lead to a 0.2 to 0.3 percentage
point increase in the economy's growth rate. This increase in growth may
sound small, but such a change would have dramatic results over
time.
Professor Rosen used this figure to
estimate that the current policy would increase the size of the
economy by $24 billion in 2010, but that making the tax rate cuts
permanent would result in an economy that is $349 billion larger in
2020 than it would be if the tax rate reductions expire in 2011, as
they currently will do unless policymakers act.
Furthermore, Rosen estimates that making
the tax rate cuts permanent would result in an aggregate increase
in the size of the economy of roughly $1.9 trillion between 2011
and 2020. In other words, the total
increase in the economy over this period would be equal to roughly
20 percent of the size of today's entire economy. Making the tax
rate cuts permanent and fully in effect now would dramatically
increase these numbers and substantially increase the long-term
economic benefits by making those benefits begin today.
No
respectable and reasonable economic school of thought maintains
that tax rate increases help economic growth. Failing to make last
year's tax cut permanent not only hurts the economy now, but
also--if policymakers do not remedy the problem before the tax cut
expires--will harm the economy in the future. When the tax cuts
expire in 2011, the reversion to many pre-2001 tax rates would mean
probably the largest tax increase in history, a policy that would
substantially depress the economy at that time. Professor Rosen
explains it this way: "If these [tax rate] reductions are not made
permanent, we should expect to see a decrease in entrepreneurial
activity at the start of the next decade, other things being the
same."
Making the tax rate cuts permanent and immediately effective would
avoid this harm to the economy.
|
The Cost to People in 2004 of Repealing the 2001 Tax
Cuts in 2003
by Ralph A.
Rector, Ph.D.
Repealing the Bush 2001 tax plan in 2003 instead of making the tax
cuts permanent and fully in effect would increase taxes or reduce
refunds for filers in all income classes in 2004. (See Table 1.)
Overall, the rate of increase in income taxes after refundable
credits would be greatest for those with incomes between $10,000
and $30,000. Many tax filers with incomes less than $15,000 would
notice the tax change as a reduction in their refundable tax
credits. Taxpayers with incomes over $500,000 would have the
smallest percentage increase.
All tax filers, including those with incomes under $10,000, would
lose the benefit of the new 10 percent tax bracket. This new
bracket lowers the tax rate on the first $6,000 of income for
single filers and the first $12,000 of income for married couples
filing jointly. The new bracket is a major source of tax relief for
tax filers with incomes less than $100,000.
Families with incomes between $10,000 and $30,000 would also lose
the benefits provided by changes in the child tax credit. Repealing
the 2001 tax cut would reduce the value of the child credit by over
15 percent in 2004. In addition, many taxpayers who pay little if
any tax would no longer qualify for the refundable child credit.
Prior to the Bush tax plan, the credit was refundable only for
families with three or more qualifying children.
Repealing the tax rate reductions, which are the source of
important economic incentives, would be particularly noticeable for
taxpayers with incomes over $50,000.
|
Reason #4: Making the tax rate cuts permanent and fully in effect
now would improve the stock market.
Even
as the economy seems to improve, the stock market has continued to
remain at low levels (despite an October rebound) because of the
tremendous uncertainty regarding the future. The stock market has
been dropping since its peak in 2000, and many investors have seen
their investments decline drastically in value--some by 50 percent
or more. Making the tax rate cuts permanent and fully effective now
would give confidence to these investors and encourage new
investors to participate, thereby shoring up the stock market.
Investors receive their returns from stock
investments from two components--regular payments (dividends) from
companies to their shareholders and increases in the stock price
from the time of purchase to the time of sale (capital gains). The
government taxes dividends at ordinary income tax rates and capital
gains at lower rates. Since government taxes both elements of
investment returns (on top of already taxing them through corporate
income taxes), the effect on the stock market of changes in tax
rates on capital gains provides some insight into how changes in
tax rates on dividends might affect the stock market.
As
history shows, when capital gains tax rates decrease, stock prices
increase. Mark H. Lang and Douglas A. Shackelford of the NBER found
that a 1997 reduction in capital gains tax rates had increased
stock prices in large part because lower capital gains tax rates
made stocks more attractive to potential investors. "[T]he results
suggest," they conclude, "that anticipated shareholder taxes affect
firm values."
A
study in 1999 by David Wyss of Standard & Poor's DRI supports
this conclusion. As Wyss notes, "Since the new law passed in 1997,
stock prices have soared 30%. About 8 percentage points (or 25
percent) of that rise can be explained by the change in capital
gains treatment."
Since lowering tax rates on one part of
investor returns (capital gains) improves stock market conditions,
reducing tax rates on the other part of investor returns
(dividends) should have a similar effect. Unfortunately, even if it
is made permanent and effective today, the cut in ordinary income
tax rates probably would not be as substantial a tax rate reduction
as the 1997 capital gains tax rate cut was. Consequently, the
positive effects on the stock market likely would not be as great.
But making the income tax rate reductions permanent and effective
now would still improve stock market conditions.
Further evidence of the positive effects
on the stock market of reducing tax rates on dividends is contained
in a study of various tax reform proposals by Federal Reserve
economist John E. Golub. According to Golub, eliminating taxes on
dividends would increase stock market prices. Lowering tax rates on
dividends by permanently and immediately reducing ordinary income
tax rates would not increase stock prices as much as completely
eliminating taxes on dividends would, but the effect still would be
positive. The policy would improve the stock market now and in the
future because financial markets represent people's current
collective view of future conditions.
Financial markets look forward, not
backward or just at today; therefore, they are very responsive to
perceived dangers and future unknowns. More confidence in the
future would lead to more investment and higher stock prices now.
Making last year's tax rate reductions permanent and fully
effective immediately would reduce an element of uncertainty now--a
"risk premium" in the market--and improve prospects for the
future.
Investors make investment decisions based
on anticipated after-tax returns, but the government incorrectly
taxes stock dividends as ordinary income. As long as a corporate
income tax exists, all other investment returns--both dividends and
capital gains--should not be taxed at all, because the government
is taxing the same income multiple times. Making the tax rate cuts
permanent and fully effective now would raise the benefits of
investing in dividend-paying stocks or mutual funds, increasing the
incentives of people to invest. Thus, decreasing future market
uncertainty and increasing after-tax rewards for investing now
would increase investment and thereby improve current stock market
conditions today.
Making the tax rate cuts permanent and
fully in place today would have a similarly positive effect on the
bond market, where prices move in the opposite direction of bond
yields (interest rates). Higher bond prices mean lower interest
rates. As in the stock market, uncertainty currently exists in the
corporate bond market with worries about the ability of companies
to repay investors. Consequently, bond investors demand lower
prices and, therefore, higher interest rates--a greater "risk
premium"--on their investments. By reducing one aspect of risk for
bond investors, making the tax rate cuts permanent and completely
effective now would decrease uncertainty about the future and lower
this "risk premium." The result would increase bond prices and
lower interest rates.
Making the tax rate reductions permanent
and totally in place today would help the bond market and lower
interest rates in another way as well. Taxable bonds (including
corporate bonds and U.S. Treasury bonds) pay higher interest rates
than do tax-exempt state and local government bonds. The difference
between the interest rates on taxable and tax-exempt bonds
represents the cost to investors of paying taxes on the taxable
bonds--the "tax premium."
Because investors make their decisions
based on after-tax returns, the after-tax returns to taxable and
tax-exempt bonds should be very similar. Therefore, permanently and
immediately cutting income tax rates would lower the tax premium
and result in lower taxable interest rates. If investors know they
will be taxed less in the future on the interest they earn from
taxable bonds, then taxable interest rates (pre-tax) will fall.
Golub concludes that tax reform--which
would eliminate taxes on interest--would decrease interest rates.As was the
case with the taxation of dividends and the positive effects on the
stock market of permanently and immediately reducing income tax
rates, the policy would result in lower taxable interest rates, but
not so as much as if Congress were to implement fundamental tax
reform to eliminate taxes on interest.
The Federal Budget
One
additional effect of making the tax rate cuts permanent and fully
in effect now is that it would likely lead to higher, not lower,
federal tax revenue--particularly in the long run--than government
collects now. Yet opponents of tax cuts still cite concerns about
the federal budget. Some, like Senator Joseph Lieberman (D-CT),
have joined Senator Kennedy and Representative Tauscher to advocate
postponing or repealing parts of the tax cut under the guise of
attempting to balance the budget.
These claims defy logic, because not
making the 2001 tax plan permanent would harm people, the economy,
and the stock market while failing to improve the government's
budgetary situation. Economic growth and restraining government
spending, not imposing higher taxes on people, is the best
prescription for balancing the government's budget. As Professor
Rosen notes, "In short, the possible budget deficits associated
with the new law are no obstacle to making it permanent."
Policymakers who genuinely care about
fiscal discipline or fiscal responsibility should focus their
efforts on limiting government spending and on permanently and
immediately removing government obstacles--that is, high tax
rates--to a growing economy. To the extent that a budget problem
exists, the fault lies in too much government spending and an
economy that is growing too slowly. In fact, studies show that the
2001 tax cuts were the cause of only 8 percent of the decline in
the projected 2002 budget surplus and less than 25 percent of the
10-year decrease in the projected surplus. The most important
determinant of federal government tax revenue is a rapidly
expanding economy--not high tax rates.
Policymakers should remember that the
economy drives the federal government budget; the federal budget
does not drive the economy. In fact, the slow economy and the
falling stock market have been major reasons for the change in the
federal budget outlook. Increasing government tax
revenue--which should not in itself be a goal of
policy--nevertheless would result from a more robust economy.
Some
opponents of making the tax rate cuts permanent and fully effective
today claim that such a policy would "cost" too much or would
"spend" too much money. Such sophistry reveals that these tax cut
opponents believe that the money belongs first to the government,
to do with as it pleases, and only secondarily to the people who
earned it in the first place. In reality, government cannot "spend"
money on a tax cut, because the money does not belong to the
government. It belongs to the people who earned it.
Government, after all, is not like a
business whose objective is to bring in as much money as possible.
In fact, government should not take as much money as it can, but
rather only what it needs to fund truly vital activities.
Policymakers should move away from the flawed goal of maximizing
government tax revenue and toward the correct goal of maximizing
economic growth by limiting the size of government, having
government take from people only as much money as it needs, and
doing so in the most efficient--that is, economically least
destructive--way possible.
Additionally, it is somewhat contradictory
for policymakers who support permanent, immediate, and ever-growing
federal government spending to express concerns about the federal
budget and advocate tax rate cuts that are temporary, delayed, and
shrinking. This position has the relationship completely backwards.
To the extent that they exist at all, government spending programs
should be temporary and continually reviewed. Tax rate cuts should
be permanent and immediate so that individuals, families, and
businesses can benefit today and better plan for the future.
With
permanent tax rate cuts, if at some point in the future
policymakers wanted to increase tax rates, they would have to argue
and vote openly to do so. In the current situation, unless the tax
rate cuts are made permanent, taxes will rise automatically without
policymakers having to vote to impose that historic tax
increase.